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Mark McLaughlin asks whether HMRC’s misgivings about giving legislative effect to Extra-Statutory Concession C16 are justified.

Introduction

Some Extra-Statutory Concessions (ESCs) are used more frequently than others, but I expect that ESC C16 is among the most common. The text of ESC C16 broadly allows distributions to shareholders, by a company that has ceased business and is awaiting dissolution, to be treated as made in a formal winding up, if certain conditions are satisfied and assurances given to HMRC.

For tax purposes, the distributions are treated as capital distributions within TCGA 1992 s 122, as opposed to income distributions under CTA 2010 s 1000(1).

Most taxpayers and advisers view ESC C16 as ‘a good thing’. This is despite concerns about the incompatibility of the concession with company law, particularly the making of ‘capital’ distributions of assets to shareholders without a formal winding up (CA 2006 s 829(2)). The problem is not lost on HMRC; more on this later.

Furthermore, the higher Capital Gains Tax rate of 28% from 23 June 2010 means that income distributions may be preferable for individual shareholders in some cases.

However, the 10% Entrepreneurs’ rate of Capital Gains Tax, if available, normally makes capital distribution treatment an automatic choice.

HMRC accept that Entrepreneurs’ relief is available in respect of a deemed capital distribution under ESC C16, assuming that the relief conditions are satisfied (see the Capital Gains Manual at CG64115). Thus ESC C16 is likely to remain tax-efficient for many individual shareholders.

Of course, ESC C16 was not introduced by HMRC as a tax planning measure. In fact, the stated purpose of the concession according to HMRC is so that 'companies may arrange to finalise the tax position of a trading company as though a formal winding up had taken place, but without incurring the extra costs involved in such action’.

In other words, the purpose of ESC C16 is to reduce professional fees. The concession was probably not warmly welcomed by liquidators, but has nevertheless been appreciated by company owners for a number of years.

ESC C16 is augmented by the Treasury Solicitor’s concessionary practice of waiving the Crown’s right to funds under ‘bona vacantia’ on the unauthorised return of share capital, where:

• the company has been struck off under CA 2006, s 1003 (or CA 1985, s 652A);
• the shareholders have obtained ESC C16 treatment; and
• the amount of the distribution is £4,000 or less.

The rationale for this treatment is confirmed in the guidelines about the distribution of a company’s share capital:

‘It has been recognised that it would be unreasonable for the Treasury Solicitor to expect that a company is put into formal liquidation when that would be uneconomic’.

Text of ESC C16

Dissolution of companies under sections 652 and 652A Companies Act 1985: distributions to shareholders

A distribution of assets to its shareholders by a company which is then dissolved under the Companies Act 1985, s 652 or s 652A (or any comparable provisions) is strictly an income distribution within TA 1988, s 209. In most circumstances and providing that certain assurances are given to the inspector before the event, the Revenue is prepared for tax purposes to regard the distribution as having been made under a formal winding-up so that the proviso to s 209(1) applies. The value of the distribution is then treated as capital receipts of the shareholders for the purpose of calculating any chargeable gains arising to them on the disposal of their shares in the company.

The assurances include:

The company:

• does not intend to trade or carry on business in future; and

• intends to collect its debts, pay off its creditors and distribute any balance of its assets to its shareholders (or has already done so); and

• intends to seek or accept striking off and dissolution.

The company and its shareholders agree that:

• they will supply such information as is necessary to determine, and will pay, any corporation tax liability on income or capital gains; and

• the shareholders will pay any capital gains tax liability (or corporation tax in the case of a corporate shareholder) in respect of any amount distributed to them in cash or otherwise as if the distributions had been made during a winding-up.

Notes

(1) References to CA 1985, s 652, s 652A have been superseded by CA 2006, s 1000 to s 1003 (the latter section dealing with voluntary striking off).

(2) HMRC guidance indicates two further conditions; i.e., that if the distributions were made in a winding up, the company would not be reported under the transactions in securities anti-avoidance rules, and that the company is not under investigation (either on its own or as part of an enquiry involving individuals or other companies (CTM36220).

What’s the Problem?

As pointed out in my article Concession C16 - HMRC Not Keen?, the House of Lords decision in R v CIR ex p Wilkinson [2006] STC 270 raised issues about the validity of ESCs and the extent of HMRC’s discretion to make and apply them.

This resulted in the introduction of legislation allowing the Treasury to give effect to ESCs (FA 2008 s 160).

HMRC subsequently stated that where an ESC exceeds the scope of its discretion following Wilkinson, the effect of the concession would be maintained by putting it on a legislative basis ‘where it is appropriate to do so’. Since then, some ESCs have been written into the legislation, while others are being withdrawn.

ESC C16 is one of those concessions seemingly outside the scope of HMRC’s discretion, so what action has been taken concerning ESC C16 in the last couple of years or so? Not a lot, it would appear.

When consultation on legislating for ESCs commenced in November 2008, HMRC placed ESC C16 into a category of ‘ESCs where clarification is needed before legislation is drafted’. This at least looked promising, as it indicated that HMRC ultimately intended to give legislative effect to the concession.

However, a letter from HMRC to the Corporation Tax Operational Consultative Committee on 3 March 2009 subsequently raised the following concerns about the concession, which I have numbered for convenience and commented on below.

1. It’s Complex

In the above mentioned letter, HMRC stated:

‘Initial reappraisal of this ESC led us to believe that the legislation required to formally implement it as it currently stands would significantly increase the length and complexity of the legislation. This is due to the fact that there would need to be an avoidance rule that prevents the legislation from being used to gain a tax advantage.’

It is not altogether clear what ‘tax advantage’ means in this context. As mentioned earlier, many shareholders will benefit from capital treatment on a distribution of assets from the company where ESC C16 is applied. Others will not.

There are inevitably winners and losers, depending on individual circumstances, prevailing tax rates and the availability of reliefs, allowances and exemptions.

Legislation to prevent a tax advantage being obtained (e.g., to the effect that the shareholder’s Capital Gains Tax liability is not less than the corresponding Income Tax liability on distributions) could prove difficult to administer in practice.

If HMRC cannot accept that a tax advantage may arise as a consequence of capital treatment, it would not surprise me to see ESC C16 being withdrawn and not replaced. This would leave shareholders with the prospect of having to liquidate the company, whether or not it was economically viable to do so.

2. It’s Not Normal

HMRC also said:

‘HMRC is also mindful of the fact that winding up is the normal process for a company to end its existence and it would be inappropriate for HMRC to seek statutory backing for a practice which encourages companies to accept dissolution in preference to a formal winding up.’

This is an intriguing statement. Who has ever accused HMRC of bias towards dissolution and against a formal winding up when applying ESC C16? Shareholders are more likely to applaud HMRC for applying some flexibility, commercial awareness and old-fashioned common sense.

Perhaps HMRC is more concerned about the mismatch between tax law (if ESC C16 becomes law) and company law, as alluded to earlier. That is more understandable.

However, if the Treasury Solicitor is comfortable about such a mismatch (within the £4,000 limit), and if it does not concern the Government enough to amend Companies Act 2006, why should it unduly bother HMRC?

3. Abusing Capital Treatment

Another comment was as follows:

‘In addition, HMRC have concerns that ESC C16 has been and continues to be used for avoidance purposes. If ESC C16 were to be legislated it would have to be in a manner that gave no opportunity for abuse.’

Perhaps we are finally getting to the nitty-gritty of HMRC’s apparent reluctance to legislate for ESC C16.

However, are taxpayers (or their advisers) really biting the hand that feeds them? It would be interesting to know what concrete evidence (if any) HMRC hold that ESC C16 is being abused, and the scale of such misuse.

For example, in how many cases have HMRC withdrawn the benefit of the concession on grounds of abuse? What proportion of ESC C16 applications to HMRC do those cases represent?

It would come as no surprise to me if HMRC’s concerns were based on little more than a suspicion, because in practice it must be very difficult to detect and accurately quantify abuse of the concession.

Perceived Avoidance

Presumably, the avoidance perceived by HMRC involves ‘phoenix’ companies; i.e., the cessation of trading and dissolution of one company by its shareholders, followed by the commencement of the same trade in a different company controlled by the same shareholders.

While I have never seen such deliberate abuse of ESC C16 in my entire tax career, I am willing to accept that it could happen.

However, I wonder whether it frequently occurs in the structured and deliberate way that HMRC apparently envisage.

Has anyone come across firms marketing arrangements to their clients involving ESC C16 and Entrepreneurs’ Relief through a consecutive series of short-term companies carrying on the same trade? One certainly hopes not.

HMRC’s guidance on the ‘Transactions in Securities’ anti-avoidance rules states the following in the context of liquidations:

‘An ordinary liquidation (in which a company is wound up following the complete cessation of its business…) is not within the scope of [the transactions in securities provisions]’

(Company Tax Manual at CTM36850).

It also instructs HMRC officers dealing with ESC C16 applications to report cases potentially caught by those provisions to HMRC’s anti-avoidance group. The guidance has not yet been updated for the changes to the Transactions in Securities provisions introduced by FA 2010 s 38 and Sch 12.

It would be unwise and potentially dangerous to use old legislation, guidance and case law for guidance in current cases.

However, the HMRC consultation document which preceded the new provisions (Simplifying Transactions in Securities Legislation, issued on 31 July 2009) indicates that revised HMRC guidance would include a section ‘Specific areas of difficulty: Interaction with ESC C16’, which suggests that HMRC still consider some cases to be potentially subject to the revised anti-avoidance rules.

New TAAR?

A detailed analysis and consideration of the present Transactions in Securities legislation, and the extent to which it could apply to distributions under ESC C16, is outside the scope of this article.

Suffice to say that, in my view, arrangements such as the phoenix company scenario described earlier are potentially caught by the anti-avoidance provisions. It would be surprising if HMRC took a different view.

However, even if such abuses are not caught by the current transactions in securities code, if HMRC wished to specifically bring ESC C16 (if legislated) within the scope of the anti-avoidance provisions; surely it would be possible for the draftsman to do so.

Of course, how easy it would be for taxpayers and advisers to interpret and apply the law correctly is another matter.

A Targeted Anti-Avoidance Rule (TAAR) is another option if ESC C16 becomes law. A TAAR is probably better than nothing.

However, if this happens, one hopes that it does not take the form of a relatively short and simple rule of law, supplemented by lengthy and complicated HMRC guidance, such as when the TAAR on allowable capital losses (in TCGA 1992 s 16A) was introduced.

A TAAR could specify certain ‘safe harbours’ which fall outside the provisions, such as for very small companies, or perhaps a rule allowing ESC C16 treatment to a shareholder every (say) four years. In any event, the implementation of any TAAR needs to be preceded by full consultation with the professional bodies over a sensible time period.

Conclusion

It is said that ‘no news is good news’. However, this is not the impression given by the period of silence and inactivity that has followed HMRC’s stated misgivings about legislating for ESC C16. It may be that HMRC simply have bigger fish to fry, or that the matter has been temporarily consigned to the ‘too difficult’ pile.

One hopes that HMRC have not decided to use their review of concessions following Wilkinson as an opportunity to withdraw ESC C16 without replacement.

The commercial rationale behind ESC C16 (and the bona vacantia concession) is sound. However, I have seen instances of the concession being applied to companies with very substantial cash balances. It would be difficult to sustain the argument that liquidating such companies is uneconomic.

A monetary ceiling could be considered above which ESC C16 treatment is not available, although whether such companies should be obliged to incur additional costs while smaller companies are not is another matter.

This article has considered various ways of dealing with some of HMRC’s perceived difficulties with ESC C16. Hopefully, those difficulties can be satisfactorily resolved, and the tax treatment afforded by such a practical and helpful concession finally placed on a statutory footing.

This article was first published in Taxation magazine on 30 September 2010.